Discounting and “Baking in”

This note is important to understand what is going on with the current earnings reports and the market reaction.  Read to the end for a nice illustration, even if the concept is one familiar to you.

The market is, of course, forward looking.  Everyone with money at stake is attempting to make predictions about the course of prices, while using a variety of different tools.

Sometimes these predictions involve specific events.  If the outcome of an event is widely expected, the stock price movement may seem (to the unsophisticated observer) to be very surprising.  When a company delivers a great earnings report, but then the stock declines, analysts nod wisely and say that the earnings had been completely expected.

There are a lot of terms for this behavior including the following:

  • Buy the rumor and sell the news.
  • Buy on the cannons and sell on the trumpets (a very old one, getting recent play).
  • The earnings and been "discounted" in advance.  (This is the best technical term, meaning that the impact was "factored in" through modeling or accounting for future cash flows.  It is ambiguous for non-professionals, since there is a sense of the word "discount" that means exactly the opposite).
  • The information was "baked in" the stock price.  (I personally dislike this one and it is already over-used, but I guess it captures the meaning.

My favorite illustration of this occurred the morning of the Iraq war.  After an evening display of "shock and awe" U.S. troops had met little resistance as they raced into Bagdahd.  Apparently friendly citizens flooded the streets and began tearing down various Saddam Hussein pictures and the like.  The stock market opened with a nice rally, and moved higher as those who had stayed out of the market now felt it was safe to make some buys.  The Iraqi’s were working on a statue of Saddam, trying to pull it down.  They did not have the right tools for this large statue, and it was going to take some time.  It was rather fascinating to watch, so CNBC stayed right there and Mark Haines extended his hours to keep covering this event.

It was pretty obvious that the statue would eventually go down.  And when it did ……the market sold off.  Whether or not the statue fell had little to do with U.S. equity prices, but that is how it traded.

Earnings Season–Fighting the Last War

The financial media has the effect of reinforcing some of the most counter-productive tendencies identified by the behavioral finance literature, described in prior posts.  On a day like today, with the market down big time, CNBC brings in those who can "explain" what has happened.  The selection bias gives the illusion that there are all of these wise heads who are figuring this stuff out in advance.

Here is the edge for the savvy investor.  Most people are dramatically influenced by early occurrences in their lives or careers.  Most hedge fund managers are pretty young, and perhaps unduly influenced by the "internet and tech bubble."  They also have in their (brief) careers some experience with corporate accounting issues, deception, lying by sell-side research analysts to foster investment banking business, a myriad of one-time charges, and other elements that exaggerate earnings.

Like  the Nobel Prize winning Pavlov‘s dogs, they have learned to be suspicious of any earnings forecast.

The problem?  They are fighting the last war!

This one is over.  The world has changed.  (There is this child’s game played by pundits, where if you dare to say that "thing’s are different" you lose.)  Well it is different to anyone who is not wearing blinders.  At "A Dash" we read hundreds of analyst reports on the stocks we follow and the changes are apparent.  Here is what has taken place:

  • Companies are much cleaner in their earnings reports.
  • Options expensing has been mandated by FASB.
  • Companies are extremely careful in their forward- looking statements.  This is not even close to the cheeleading days of 1999 and 2000.  I followed interviews in 2003 very carefully, and CEO’s were all conservative in front of the Iraq war.  Companies do not give encouraging guidance unless they can really see it.
  • Sell-side analysts are more conservative — much more conservative.  They have a higher number of "hold" and "sell" ratings, even though the coverage universe is smaller.
  • Analysts try to guess the economoy to find some sell ratings.  When the specific information from the company does not justify lowering earnings, they produce some authentic Wall Street Gibberish about how this is the peak of the cycle.  That means that they have decided to predict the economy, instead of following their stock.

Pundits who are stretching the mileage from their "bubble era" analysis, continue to say that analyst estimates are exaggerated and "must come down" even though these estimates have already been normalized, discounted, and discounted again.

There are many pundits and hedge fund managers who harbor this view.  For some time now, when the prediction has been incorrect, the PE multiple for stocks has just gone lower.  Since "everyone" knows that earnings will move lower, it makes sense to "bake in" a lower multiple.

The next segment will see how that approach has worked…..


Readers of "A Dash" will already be familiar with much of Jack Miller’s list of things he knows.  It is worth looking at these items as a collection, and also considering his conclusion.  A strength of his approach is that he thinks about the relative value of various asset classes.


A couple of regular readers have asked if yesterday’s huge rally is the start of the BIG BULL I have been writing about. I don’t know!

Apple Chart

Apple (AAPL) stock has been under some pressure.  There are a number of interesting issues, nicely laid out by Barry Ritholtz in his commentary on the recent price action.

Should we pay attention to this or to the fundamentals?  What about the stock options controversy.  Take a look at Barry’s view, and then consider some other thoughts.

Link: Apple Chart.

I am a big fan of Apple for many years — like the company, the iPod, the Macintosh, and even some of Steve Jobs’ schtick. But looking objectively at the chart, this is a stock facing some problems: a series of lower lows, possibly pulling back towards …

Continue reading…

The Old Days

Thirty-five years ago a small group of students met in a seminar room in Ann Arbor.  These students were planning careers that would lead into the quantitative analysis of public policy, an idea much in vogue at the time.  Important public decisions might be made not just on the basis of politics, but on the policy impacts, costs and benefits, and economic efficiency.

The students were taught by leading faculty members at a top resesarch institution, learning about administrative theory, organizational behavior, economics, and research methods.

On this particular occasion the group of first-year students was eager to show their stuff.  They wanted to impress their young professor, a man who would later be recognized not only as a first-rate teacher, but a top scholar in his field.

The professor led the seminar by introducing a series of findings drawn from social science literature.  These were relationships like voting patterns of black males, party identification of former military personnel, and the like.

As he introduced each finding, the professor invited the students to comment, suggesting hypotheses to explain the results.  Straining to please, the students had many imaginative suggestions.  Their ideas would have filled out many journal articles.  They were showing off, and happy to do so.  The professor provided some positive feedback for the thoughtful analyses, and ticked off a dozen or so propositions.

At the end of the seminar, the students sat back, satisfied with their performance.  The professor congratulated them on their creativity and imagination, and everyone sat up a little taller.

Then the prof dropped the bombshell:

The actual findings were all EXACTLY THE OPPOSITE of what he had stated!

The next day’s assignment was to come back with new hypotheses for the other finding.

This is an extremely important lesson.  Analyzing lots of data, with hundreds of possible relationships, will always yield some findings — statistically significant!  Fertile minds can figure out some logic to explain these findings.

That approach is backwards.  Good research begins with theory and hypotheses and then moves to testing.

In one sense it is a shame that Wall Street researchers did not get this kind of training.  If one looks carefully at their reports, it is pretty obvious when a researcher is "data mining" and when there is some theory behind the work.  A key question is: Which came first?

The Biggest Investor Mistake

For most people, the information in today’s post is probably more important than any other single fact they can learn about investing.  Understanding and following this advice could make a million-dollar difference for a middle-class family thinking about college and retirement.

The problem is that the advice is extremely difficult to follow.  Since very few individuals will follow this advice, it is yet another source of market inefficiency.  It explains why Warren Buffett and other managers can maintain a positive expectancy in gains over the market.

Ready?  Here goes —

Don’t sell the bottom!

Don’t do it with stocks.  Don’t do it with mutual funds.

Let me explain the psychology first, and then show you some persuasive evidence of the effects.

They psychology comes from our desire to control, and the feeling that we can control our investments.  There is a strong marketing interest in persuading investors that they can and should make their own decisions.  It is profitable for brokerages, and they run many ads to that effect.

They show the "Power Guy" with his fancy trading tools telling a broker (as if he would really be talking to a broker in these days of online trading).  The Power Guy says "OK, I’ll buy a thousand shares, but if it goes down, I’m going to dump it!"  Firm, decisive, and wrong!  The market creates all sorts of movements in stocks.  If your fundamental reasons are intact, you should be prepared to buy more.  But it certainly sounds good.  The TV commercial plays upon our desire to show that we are in control, and that this sort of decisiveness makes sense.

Another commercial theme for Diamonds (the ETF that is a Dow 30 equivalent) highlighted a woman who did not have the time to study individual stocks, but who had a "feel for the market."  Just what people need — not!  Encouragement to try market timing based upon casual knowledge.  I wonder how much people have lost following that commercial.

And then there is the guy who spots a good investment because he is buying jeans for his daughter.  This is a perversion of some great advice from Peter Lynch.  It is fine to try to spot trends early. This provides a nice starting point, not the reason for an immediate investment.

The sad result is that individual investors make 1/3 to 1/2 of the market returns in every study I have seen on the subject.  Here is one such study, and there are many more.

Warren Buffett says the following:

"You can’t get rich with a weather vane."

"The market is there only as a reference point to see if anybody is offering to do anything foolish.  When we invest in stocks, we invest in businesses."

If you are not studying the individual companies, the financials, the trends, you are not analyzing the business.

In many stocks right now the market is offering an opportunity.  There is an extremely high level of concern, not about current conditions, but about an expectation that the Fed or oil prices or budget deficits, or something, will ruin the economy.  Before concluding that the market (which has predicted seven out of the last two recessions) has some great message, the investor should get some evidence.

The studies also show that the average investor applies the same criteria to investment managers, selling funds that did poorly recently to buy those that did well.  The investor is not making a careful decision because this strategy has been proven to work.  In fact, it has been proven to be a loser.  Investors behave this way because they want a simple rule, called a heuristic in behavioral finance, and this is the only information they have.  It gives the illusion of control, and costs them many thousands of dollars.

Warren Buffett on Market Efficiency

Warren Buffett is generally acknowledged as the world’s greatest investor.  He has gotten a lot of well-deserved publicity this week for his plan to give away most of his wealth.

Spending some time thinking about his success is a good exercise for anyone interested in markets or investing.  Janet Lowe’s book collecting useful wisdom is a good source.

Warren Buffett does not believe that markets are efficient.  If they were, he would have no advantage.  On the contrary, he feels that he gains an advantage from those who take the theory too seriously.

"I’d be a bum on the street with a tin cup if the markets were always efficient."

"Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards."

(Personally, I prefer to think of it as opponents who do not look at the cards!)

"It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn’t do any good to think."

Warren Buffett has spent a lifetime finding seriously mis-priced stocks to buy.  It is little wonder that he sees the market as inefficient.  Does that mean that Nobel prize-winning professor lose to the world’s greatest investor?

Markets are not (very) efficient

In my years as a college professor, I had more than a passing acquaintance with general investment theory.  I was interested in the subject, and did well with my personal account.  Despite this success, I believed that markets were efficient.  The Efficient Market Hypothesis had gained credence in academic circles, was taught in classrooms, and earned Nobel prizes for the theoreticians.  It made its way into popular literature.  The Wall Street Journal even started a feature comparing the stock picks of experts to the stock picks generated by throwing a dart at a page of stock prices.  The darts did pretty well.  John Bogle was a pioneer with this concept, introducing the first index fund on the S&P 500.  He wrote articles and spoke in front of influential audiences, pointing out the failings of fund managers, most of whom do not beat the market averages.  Thinking that you could beat the averages by picking "hot" fund managers was misleading.  There will always be managers that will do well and managers that will not, but it is a function of randomness.  An excellent book on this subject by Nassim Taleb explained this concept in more detail.  I purchased many copies of the book and sent them to my investors so that they could begin to understand how to distinguish expected performance from past results.  Any investor could profit by reading even a small part of Taleb’s book.  It is well worth the price.

I began work in the investment business providing models and research support for options traders, market makers in the Chicago Board Options Exchange, known in the market as the CBOE (see-bow).   I  began this work for professional traders, trading their own money (and often that of backers) for their own accounts because the traders had an edge.  They bought options on the bid and sold on the offer, conferring an inherent advantage.  The traders needed modeling support and fundamental analysis of the stocks.

As I did this work, I operated with the open mind of an academic researcher.  Gradually I became convinced that there were significant market inefficiencies.  This is extremely important.  The opportunity for the investor comes when others are making mistakes.  If markets are not really efficient, there is opportunity.  The problem comes in determining the sources of the inefficiency and knowing how and when to react.

This concept is crucial to investment management.  If markets are efficient, managers could not show excess returns.  I learned that individual investors made many mistakes, and that their personal accounts showed about half of the gains of the market averages.  They would indeed do better to buy an index fund.  I also learned that the recommendations of analysts at the major firms were a contra-indicator, even though followed by many institutional investors.  The premise was simple:  If the analysts were all in favor of a stock, their followers were already all-in.  The key was to find great stocks that were currently unloved by the analyst community and by individual investors.

I reached this conclusion long before the recent disparging of analyst research, assorted scandals, and the like.  My investors enjoyed great returns from following a contrarian strategy.  The gains did not always happen over night, but they came with time.

I intend to elaborate on this concept, the source of the inefficiencies, why they occur, and what opportunities results.  But first, I need to elaborate on the evidence that markets are not really efficient.  It is a difficult but important concept.

An Interesting Week

Most of the writing I do is on sites exclusively for clients.  This is especially true for the analysis of specific stocks.  Sometimes a theme is also suitable for "A Dash," and tonight is such an occasion.  So here is part of my nightly investor commentary, omitting our daily result and position discussion.

CNBC just reported that the market was up strongly today because of strong corporate earnings. suggests that sense there was no Fed news nor economic news of significance the market could pay more attention to earnings.

Today and yesterday show how little sense there is in most attempts at “explaining” specific trading day results, even moves of 1% or so. Journalists are required to write something, but we do not have to believe it!

There was good earnings news from Morgan Stanley and from FedEx. True enough, but no different from the reports of Merrill, Goldman Sachs, and others in the investment banking space, nor Caterpillar and other cyclical companies.

On May 10th the market focus changed to all Fed, all the time. We got a parade of Fed governors making speeches about their inflation vigilance, plenty of market punditry suggesting that the Fed could not stop inflation nor save the economy. Sector PE multiples were crushed (even further by our lights) for anything related to economic strength — energy, construction, steel, machinery. Many of these stocks declined by 20% or more in about a month. If the economy was to be weak, then technology must also be bad. Since trading and investment banking would be bad, those stocks should also be sold. And what about the yield curve? The fact that it did not matter a few months ago did not deter the same folks from trotting out the same arguments about the economy.

There can be a self-fulfilling prophecy about such stock declines. Analysts started to report that the market was “telling us something” about the economy, and that the Fed should listen. In other words, the market moved lower because of a concern about what might happen. Then some interpreted it as evidence that something would happen.

Over the last few days the sentiment on the economy has changed a bit. Not only are corporations reporting great quarters, but the CEO’s are making more confident statements about global economic strength.

We expect a significant shift in attitudes about the economy, corporate profits, and the relative value of stocks. Market moves like we have seen in the last week illustrate how this might happen.

What’s Going On?

Since the Fed decision to increase interest rates on May 10th, the market has taken a completely different character.  The Fed did not signal that a pause in the rate hike regimen was imminent, leaving the door open for policy flexibility.  Some market participants interpreted this to mean that the Fed was going to kill economic growth.  As a result, they started selling any stock that had a cyclical character.  When this selling started, hedge fund managers on a short-term momentum strategy also started selling.  Individual investors joined the panic.  Even some investment managers now say that it is time to stand back and see where buying emerges.  Technical analysts note that the major averages are in a downtrend and have fallen to critical support levels.

What is wrong with this?

The key point for any investor to grasp is the need to look forward, not backward.  The fact that stocks have declined, and that cyclical stocks have declined the  most, is a backward-looking event.  The key question is whether the "marginal trader" in the market is really looking forward.

How to find the facts?

Our view at "A Dash" is eclectic.  We do not pretend to know the answers, but we are very good at recognizing the experts on each issues.  Partly we do this based upon their past performance, and partly it is based upon the logic of the analysis.

It is important to understand that the markets are not really efficient (more on this in upcoming posts) and that one needs to parse the commentary to learn the facts.

  • The economy.  The facts are that it is very strong.  The economic strength has continued in spite of increased energy prices and a series of interest rate hikes.  The reason is that energy prices are less important than they were thirty years ago.  There has been a drag on the economy, but it is still strong.  The real evidence is from consensus economic predictions and also the predictions from CEO’s in the Business Roundtable.  Both show strong growth.
  • Corporate profits.  The naysayers have been predicting that earnings estimates must decline, and they have been saying this for two years.  They have been wrong, and they are still wrong.  Corporations have strong balance sheets.  Profits have increased at double-digit rates for a record period of time.  Estimates are still rising.  Corporations got lean and mean in 2001 and have expanded cautiously.  They are poised to take action, spending to stimulate growth and buying back stock.
  • Inflation.  This is a widely misunderstood topic.  Hedge fund managers and pundits think that they understand inflation better than the real experts.  There are good indicators of expected inflation.  Things like the spread between TIPS (inflation protected bonds) and regular bonds show modest inflation expectations.  Economists predict the same.  The ten-year note is at a modest 5% yield.  These are the facts.  It is easy to find anecdotal evidence of some higher prices, but more difficult to balance this with the overall picture.
  • The Fed.  The Fed looks at specific inflation indicators, mostly geared to personal consumption (the PCE index) and core inflation rates.  They do this because of the volatility in other inflation measures.  Consider this:  If oil and gas prices remain at current levels, that does not portend additional inflation.  If the economy is slowing a bit, not crashing, but easing to normal strong growth levels, this does not stimulate more inflation.  The Fed’s mission is to kill the expectation of more inflation, so that we do not get a spiral of wage and price increases.  At the moment there is no indication of such a spiral, and the Fed wants to keep it that way.  The new chair, Mr. Bernanke, got off to a slow start with some dovish commentary.  He wants to kill inflationary expectations, as he should.

How Do We Make Money from This?

Let’s start with how one loses money, which is blindly following those who have been wrong and ignoring the real experts on the economy and inflation.  We have the sweet spot of forecasting when economists and CEO’s agree.  There is a disconnect between their read, and that of the average investor and the rookie hedge fund managers.  This is an opportunity.

Our models show the market as a whole to be undervalued by 35% and cyclical stocks, tech stocks, and selected biotechs undervalued by 50%.  Even if we are wrong by a fair margin, it is a great buying opportunity.

Is the Current Market in a Crash Situation?

Those making comparisons with 1987 or 2000 are not looking at fundamentals.  Corporate earnings are strong, much stronger than in 2000.  PE ratios are low, and even lower when compared to interest rates.

Are We Entering Stagflation?

A problem with using the ‘staglfation’ term is that most of the current managers were not following the market in the 70’s when interest rates soared above 15% and growth went to recession levels.  There is no comparison to today’s market.

There is a little more inflation than a few years ago when the problem was global deflation — a serious economic risk.  A little inflation goes with the territory of economic strength.

How Will It Play Out?

The key question is whether the Fed balances interest rate tightening with economic expansion.  Most maket players are following a simple heuristic:  Don’t Fight the Fed.  This is alliterative and makes a lot of sense when the Fed is determined to crush the economy to stop rampant inflation. That is not the current situation.  Most of the Fed tightening simply brought interest rates from an extremely low level, designed to combat deflation, back to a "neutral" range.  We are now in that neutral range.

Looking at every Fed tightening cycle for the last 60 years is not very helpful.  Almost all of these cycles started from much higher levels and faced different inflation situations.  The only circumstances that were vaguely comparable were from the Eisenhower era, when the landscape of derivatives, adjustable mortgages, world trade, and other factors were vastly different.  Despite these obvious problems, one of the major research houses — widely quoted on TV and followed by hedge fund managers and pundits — reports these results as if they were indicative of the current situation.

What to Do?

The current market, as it has been since 2004, remains the opposite of the 1998-99 market.  There is a great opportunity for investors who do not follow the crowd.  The exact timing is difficult.  No one knew exactly when the 2000 "bubble" would burst.  We cannot know with certainty when this "reverse bubble" will play out.

Having said this — sometime pretty soon the Fed will pause, trying to assess the impact of past actions while still talking tough.  Stocks will rise.  Hedge fund managers will jump in to chase performance.  Individual investors will see more opportunity in stocks than in real estate, already showing weakness.  Mutual fund managers will allocate away from emerging markets.  Momentum investors will pile on.

The asset allocation among stocks, bonds, and real estate will reach equilibrium.  More likely, stocks will overshoot.  When this happens, we will shift out of stocks, just as we did in 2000.

Our method has gotten the big cycles just right.  This one is taking longer than expected — torturing us — but the facts have not changed.